private equity players
Boon or scourge?
How foreign financial investors can strangle domestic promoters
by ALAM SRINIVAS
A young MP recently called me, asking to be briefed about foreign private equity (PE) players who had invested huge amounts in Indian companies. He wanted to raise issues related to them in Parliament. Then, an official source spoke to me about the growing political clout of foreign PE firms, revealing how they had been able to alter a critical clause in a key notification issued by the Department of Industrial Policy and Planning (DIPP).
Not much is known about PE investors’ sources of money, their considerable influence on Indian managements (owners/promoters) despite having minority stakes, and the role they play in bringing global best practices to India. Working in this hazy environment, some of them feel they are the cat’s whiskers while others contend that they act merely as financial investors.
Of relevance is an aggressive legal battle being fought in Delhi High Court and within various government agencies, including the RBI. It is between Amar Ujala Publications, which owns a chain of Hindi newspapers, and DE Shaw, one of the largest global PE firms with access to $21 billion, of which around $2 billion has been invested in Indian listed and unlisted companies.
DE Shaw put in Rs 117 crore to buy an 18% (minority) stake in the newspaper in 2006. Late last year, unable to find an exit option, which is usually through an IPO (Initial Public Offering) in an unlisted company like Amar Ujala, it decided to sell its holding and that of the Maheshwari family (majority promoter group) to recover its investment. Talks were initiated with competitors like the Dainik Bhaskar and Hindustan Times groups.
The Maheshwaris were shocked. How could a minority shareholder insist on forcing the promoters to sell their stakes to a competitor? How could an Indian businessman lose control over his company because the proposed IPO had been delayed several times due to adverse stock market sentiments? When the Maheshwaris refused to be cowed down, DE Shaw showed them a number of clauses in their contract that allowed the PE firm to do so.
It led to legal cases in the Company Law Board and Delhi High Court. The fight jolted policymakers in the RBI, Finance Ministry and DIPP, who had completely overlooked such scenarios. Or had they deliberately turned a blind eye? More important, it revealed other clauses in the agreements between global PE firms and Indian managements, which could be deemed to be against existing policies or loaded in favour of the former.
Risk-free equity, fixed returns
EQUITY, by definition, is risky. Investors should be ready to absorb losses if the market moves contrary to their expectations. In unlisted firms, they should accept the fact that the IPO offer price could be lower than their estimates or may be inordinately delayed. But this is not true for the global PE firms. They have a safety clause inbuilt into their contracts. In unlisted firms, if they are unable to exit through an IPO, when they offload their shares at a premium they still make profits.
If the PE firms exit on a fixed-return basis, should their investments be qualified as FDI (foreign direct investment), which is equity, or as external borrowings (debt)?
Through a complicated formula and a complex derivative route (“put options”), PE firms insist that the promoters of unlisted companies buy back their shares at the original price and also pay a fixed return. In some cases, the return is fixed at 10%, compounded on an annual basis, but it can be as high as 25% (as with Amar Ujala). Therefore, the investment by PE players is riskaverse; their returns are guaranteed, as is generally the case with debt (interestbearing) instruments.
This raises several policy-related questions. If the PE firms exit on a fixed-return basis, should their investments be qualified as FDI (foreign direct investment), which is equity, or as external borrowings (debt)? In effect, should they be allowed to enter India through the FDI route at all? Finally, should the buyer (Indian promoters) cut TDS (tax deducted at source) on the global PE firms’ interest income at the time of exit?
These grey areas and doubts have drastic implications. To understand them, one has to figure out the preferred route and sectors for the global PE firms. A recent study, which analysed almost 2,750 instances (worth $81 billion) of FDI inflows between 2004 and 2009, stated that PE, along with venture capital and other forms, comprised 27% (around $22 billion) of the total amount. Almost three-fourths of the PE inflows came through the automatic FDI route, and nearly 40% of the PE money was invested in the construction and real estate sector.
More important, over $3 billion of the PE inflows constitute what is called round tripping. The term is used when companies owned by Indian businessmen abroad invest in the country through tax havens. The sources of their money can either be black money generated in India and stashed abroad, money raised globally, or earned from past investments in foreign countries (FDI outflows). “In a way… control over the investee company remains with Indians who have a strong base in India…,” said the study.
NOW, the consequences of this analysis. Most of the PE amount came through the automatic FDI route, with no questions asked about either the source of money or purpose(s) of its investment in India. The bulk goes into real estate and construction, the two sectors which generate the maximum black money in the country today. A part of the inflows constitute round tripping, and can be partially made up of black money generated by Indians in India or abroad.
A recent study of FDI inflows between 2004 and 2009 stated that PE, along with
venture capital and other forms, comprised 27% (around $22 billion).
So, if such inflows are designated as external borrowings, and not FDI, the global PE firms will have to reveal where the money has come from and where it is going. They will need to submit additional documents and proofs to establish their claims. They will need to seek specific permissions from various government agencies to bring in the money and take it out. In effect, they will be under greater government supervision. This is exactly what the PE firms do not want.
But once this aspect became public knowledge due to the legal wrangling between Amar Ujala and DE Shaw, the RBI woke up. It felt that such fixed return PE should be treated as debt, not equity. Finally, the DIPP came out with a circular, with a clause stating that henceforth this will not be treated as FDI. It was a huge blow to the foreign PE firms, as it enormously restricted their entry and exits from Indian firms, especially unlisted ones.
The PE investors were up in arms. They convinced the government that the “put option” clause was critical; unless their returns were safeguarded, no global PE firm would invest in India. They claimed that, apart from money, they bring in management expertise, global best practices, and other systems that help the Indian firms to grow exponentially and become globally competitive. Within days, the DIPP withdrew the controversial clause.
IN both listed and unlisted companies, PE firms, despite their minority stakes, exert huge control over crucial board decisions. These are included as part of a long list of 24 “affirmative rights” in the contracts. Although the rights may vary from one PE investor to another, there are some that are common in most agreements. These include a veto power by the directors appointed by the PE firms on issues such as minor alterations in annual business plans, changes in equity capital, mergers and acquisitions, launch of new products, and additional expenditure on promotional activities.
The logic behind these seemingly all encompassing rights is three-fold. One, they are not prohibited by Indian laws, existing FDI policies, or guidelines issued under FEMA (Foreign Exchange and Management Act). Two, the Indian courts have maintained that if these rights are included in the company’s articles of association, and these changes have been cleared by the shareholders, there is nothing wrong with them. Hence, all PE firms insist on these changes as a part of the contract.
Finally, these rights are important, especially in unlisted companies, since the foreign investor has no other recourse to corrective action if the management and/or the majority promoters take wrong business decisions. In order to protect their money, PE firms need to have a certain influence in board meetings. This is the reason the “affirmative rights” are considerably diluted in the case of listed companies, since all shareholders have to be treated pari passu, or the same.
However, it can be argued that PE investors consider a certain company or sector because of its growth potential. They realize that they can make a killing later by selling their shares at higher prices. They understand that existing managements and promoters are capable of taking the company to new heights of profitability. Therefore, the PE investors cannot remain minority partners and also interfere regularly with important business decisions.
A legal battle is raging in Delhi High Court between Amar Ujala newspapers,
and DE Shaw, a large global PE firm which has invested $2 billion in Indian
listed and unlisted companies.
Tag along, or drag along
THESE are possibly the two worst clauses in the agreement(s) between global PE firms and Indian promoters. They have been debated and discussed in the context of Amar Ujala and DE Shaw. The “tag along” rights are simple: if the majority promoters sell a part of their stake to a buyer, the PE firm has the discretion to sell a part or whole of its holding to the same buyer at the same price. This is a sort of indirect exit option for the minority shareholder.
But the “drag along” rights are notorious and totally biased in favour of the PE players. They state that if the unlisted firm is unable to launch an IPO within a prescribed time period, and if the promoters refuse to buy back the PE firm’s shares, along with the fixed returns, the latter can independently forge a sale deal with a third party, including a competitor. In addition, the PE investor can legally force the promoters to sell their entire stake to the same buyer at the same price.
Such clauses imply that the Indian promoters will lose control over their company simply because of stock market conditions or their immediate cash flow situation that prevents them from buying out the PE investor. In addition, the company can be sold to a competitor, and the Indian owner can do nothing about it. How can a minority shareholder even dare to ask a majority owner to do this?
Can a similar situation be envisaged in the case of listed firms, where institutional investors such as FIIs (foreign institutional investors), banks, financial institutions, HNIs (high net-worth individuals), and other powerful entities have substantial stakes and interests? Obviously not, as these institutions will insist on a shareholders’ meeting to decide the issue. They can also side with the existing management or promoter to stall any such moves made by the PE firm.
However, the counter logic is that “drag along” is crucial in the case of unlisted companies. The reason: without these rights, the Indian promoters can invariably stall the exits of the PE firms forever, and the latter will be stuck with their money in dud, or unprofitable, entities. As PE firms have a fiduciary responsibility to their own investors, they need to have a safe and unrestricted exit mechanism. Or else they will be cagey and apprehensive in investing in unlisted firms.
It finally boils down to the sanctity of the contract, ie the letters of the agreements, or the spirit in which the investment deal has been concluded between the Indian owner and the PE firm. In terms of legalese, the majority owner has to adhere to clauses he/she has accepted while signing the contracts. But then PE investment is not generally supposed to result in a change in management, unless the owners have bungled, siphoned off money or destroyed the company.
Recently, as in the case of Lilliput, PE investors have approached the Indian courts to affect a change in management and ownership. The same rules need to be applicable in all cases. Even contractual obligations have to be challenged legally. It is in this context that the battle between Amar Ujala and DE Shaw can set unparalleled precedents for the future. It will decide the future basis for PE inflows into the country. As will changes in existing laws. g
(Study done by Institute for Studies in Industrial Development (ISID), New Delhi, in February 2011)